RBS Will Have A Tough Time In The Coming Years, But The Impact On Its Share Price Is Exaggerated

The Royal Bank of Scotland Group has seen its shares sink by nearly 50% since the beginning of the year. While major banking giants globally have seen their share prices take a hit following the U.K.’s Brexit vote, RBS has been hit particularly hard by the fact that its revamped business model focuses almost entirely on the U.K., and also because the British government is the bank’s largest shareholder with a 73% stake. To make matters worse for the bank, it has reported a string of poor operating performances primarily due to over-sized legal and restructuring costs.

However, we believe that RBS’s shares are substantially underpriced, with investors underestimating the strength of the bank’s new risk-averse business model. While the bank is likely to face sizable headwinds from the U.K.’s decision to leave the European Union in the coming years, the effort it has put in since the 2008 downturn to reorganize itself as a streamlined loans-and-deposits bank should help it create value for investors even under the difficult economic conditions expected to follow.

We recently revised our price estimate for RBS’s stock downwards from $8 to $7 to factor in the anticipated slowdown in Britain’s economy over coming quarters and also to include the sharp devaluation of the British pound with respect to the U.S. Dollar over recent months. Our new price estimate is still roughly 40% ahead of the current market price – something we attribute to extremely bearish investor sentiments towards banking stocks in general and towards RBS in particular.

RBS began the year with its shares trading at just under $9, but the price has been hovering around $5 since mid-July. The impact of Brexit on the U.K.-focused banking giant was the single biggest factor behind the sharp decline, as the bank’s shares fell from $7.50 apiece just before the Brexit referendum to below $4 within a few days. While the uncertainty surrounding the impact of Brexit on U.K.’s economy resulted in a sell-off in RBS’s shares, a second sell-off soon followed when investors realized that the British government will now be forced to delay plans to offload its majority stake in RBS. This indicates that the bank is unlikely to announce any dividends until at least 2018.

The bank has also lost a chunk of its share value due to the string of operating losses it has reported. When RBS reported strong profits for Q2 and Q3 2015, investors believed that the banking giant had finally turned the corner after losing billions nearly every quarter for years. But the happiness was short-lived, as the bank churned out three more quarterly losses in Q4 2015, Q1 2016 and, unexpectedly, also in Q2 2016. While weak market conditions and shrinking net interest margins are issues that have bogged down revenues for banks globally, RBS’s poor results over recent quarters have been almost completely due to heavy legal and restructuring costs. To put things in perspective, the bank reported £1.15 billion ($1.5 billion) in average litigation and conduct costs, and another £400 million (~$550 million) in average restructuring costs for the last three quarters. Taken together, this represents more than £1.55 billion in non-recurring costs for a quarter – almost 55% of the £2.85 billion in total revenues the bank reported on an average for the period.

One-time costs have plagued RBS in every quarter since 2011 – especially costs related to the bank’s mis-selling of payment protection insurance, which has already cost it £4.7 billion over the years. Further, it could potentially cost the bank millions in additional redressals in the near term. The impact of these costs on RBS’s core U.K. retail banking business since 2011 is evident from the chart above, which captures expenses for the division as a percentage of revenues.

Moreover, RBS has reported an increase in loan provisions for the first two quarters of 2016 after reporting a release in loan provisions for each quarter from Q2 2014 to Q4 2015. We do not believe that RBS building its loan provisions is a cause for alarm, though, as this indicates that the bank’s charge-off rates are now normalizing after a phase of high charge-offs in the wake of the economic downturn followed by a period of unusually low charge-offs over 2014-15.

RBS Has Gotten Several Things Right

One of the largest banking groups in the world before 2008, RBS has gone through the most extensive reorganization among global banks – reducing total jobs across its operations from 226,400 at the end of 2007 to 89,200 at the end of Q2 2016. While a major part of this downsizing was mandated by the European Commission as a condition for RBS’s bailout, most of the changes over the last few years have been driven by a strategic shift from a diversified business model to one focused on retail and commercial banking operations in the U.K.

The focused restructuring has helped RBS’s common equity tier 1 (CET1) capital ratio swell to 14.5% – making it one of the best-capitalized banking giants in the world. The huge capital buffer will play an important role in helping the bank absorb any loan losses that may occur in the event the U.K. economy takes a turn for the worse.

Also, the bank has been able to achieve adjusted cost-to-income ratio figures of 58% and 55% for its core U.K. retail banking and U.K. commercial banking divisions, respectively. This can be attributed to RBS’s efforts to streamline its operations in the U.K., and should ensure that the bank remains profitable even if revenues come under pressure from an overall reduction in activity levels across the U.K. in the coming years.